The Distribution of the Instrumental Variables Estimator and its T-Ratiowhen the Instrument is a Poor One

Abstract

When the instrumental variable is a poor one, in the sense of being weakly correlated with the variable it proxies, the small sample distribution of the IV estimator is concentrated around a value that is inversely related to the feedback in the system and which is often further from the true value than is the plim of OLS. The sample variance of residuals similarly becomes concentrated around a value which reflects feedback and not the variance of the disturbance. The distribution of the t-ratio reflects both of these effects, stronger feedback producing larger t-ratios. Thus, in situations where OLS is badly biased, a poor instrument will lead to spurious inferences under IV estimation with high probability, and generally perform worse than OLS.